Now that economies across the world are slowly reviving, the talk has shifted to the timing of “exit strategies”, a rolling back of the extraordinary amounts of monetary and fiscal stimulus that governments and central banks had injected into their economies. Stock markets, for instance, are on tenterhooks wondering whether the withdrawal of these measures would affect growth and liquidity. There’s also the concern, though, that governments have overstretched their balance sheets and they must do something to reduce their deficits, a concern seen recently over the Greek government’s deficit. But what has been the historical record—how rapidly have central banks implemented an “exit strategy”?earlier??The timing of the exit strategy, particularly in the US, is particularly important for the markets, as monetary and fiscal tightening will have an impact on global liquidity, which has buoyed up asset prices till recently. In their recent NBER paper, economists Michael Bordo and John Landon-Lane examine the historical evidence with a view to determining whether the US authorities will tighten sooner rather than later as the economy recovers from its latest recession.
The authors point out that the risks are enormous—tighten too soon and the economy risks being pushed into a double-dip recession, as had occurred during the Great Depression; tighten too late and the economy could overheat and it could result in inflation, as happened in the 1960s and 1970s and which led to the great inflation of the 1970s.
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The authors examine every US recession since 1920 in order to spot the trends. They find different results for recessions pre-?and post-World War II. Before the War, the US Federal Reserve would tighten monetary policy when the price level turned up. This would cause it to tighten too soon. But, after World War II, the Fed tended to postpone tightening till unemployment started to trend down and this led to a resurgence of inflation. Further, the authors noticed a difference in the business cycles before 1965, when the Fed adhered to some form of convertibility of the dollar to gold, and cycles after 1965. Post-1965, in the 1960s and 1970s, the Fed waited until unemployment declined before tightening and gave little weight to inflation. This changed in the 1980s, when the then Fed chairman Paul Volcker tightened policy even though unemployment was very high and was able to break the back of inflation.
What about the most recent episodes? This is what Bordo and Landon-Lane say: “In the last two cycles, in the early 1990s and early 2000s the Fed, concerned with persistent unemployment (“a jobless recovery”), waited too long. In the first case, significant tightening occurred close to three years after the trough following “the inflation scare of 1994”. In the second case, the Fed, concerned with the risk of deflation, waited four years after the trough and accordingly may have ignited the housing price boom which burst in 2006 leading to the current recession. The recent episode with unemployment at over 10% and low inflation may be similar to the two preceding cycles.”
More precisely, they say that if the Fed follows the exit timing patterns for most post- World War II recessions and if unemployment is seen to peak in the fourth quarter of 2009, then tightening is likely to begin in the first half of 2010. But they also say that “if unemployment declines slowly from its current elevated level, political pressure or the Fed’s experience from the last two recessions may stall the tightening longer.”
Most recently, the Fed has said that, despite the US unemployment rate coming down from 10% in December to 9.7% in January, unemployment is expected to stay within 9.5-9.7% in 2010. That is why most economists are predicting that the Fed will begin to tighten only in the second half of the year. Till that happens, liquidity will continue to be abundant.